TMFPostOfTheDay (< 20)

Is 1% the New Normal Growth Rate?

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Pretty much everyone agrees that GDP growth is vital for the US to restore fiscal balance and job creation. Both political parties claim to have the best formula to increase the growth rate. Washington plans to bridge the gap between taxes collected and spending mainly through growth. We have all heard the phrase “we will grow ourselves out of it.” The other options of cutting spending and/or raising taxes seem unattainable.

What happens if Washington is NOT able to find the magic formula to improve the growth rate? Maybe they have lost the key to the safe containing GDP growth pixie dust. Over estimating long term growth has been standard operating procedure for both parties for many decades. The current White House and CBO projections are for 4% GDP growth in 2014 through 2017. Recent GDP growth has been coming in at less than 2.0%.

Ed Easterling wrote about GDP growth and the consequences for investment returns in his book Probable Outcomes. [1] Ed showed that GDP averaged 3.3% from 1900 through 2009, but has slowed to 1.9% in the 2000’s. Ed posed the question whether this was a onetime drop or if it was the new norm.

Rob Arnott’s firm, Research Affiliates, released a white paper today entitled 1% . . . The New Normal Growth Rate? [2] As the title implies, the paper suggests that the long term US growth rate might have dropped down to 1%, which is quite a change from either 3.3% or 4.0%. Research Affiliates has published several papers in this area the last few years, so this paper is essentially the latest in a series.

They detail three factors for lower GDP growth:

1. Population Growth. The model that economists use assumes the more people you have, the higher the GDP in nominal terms. This is certainly true if a country can maintain the GDP per capita while adding more people. I am skeptical if this is still a valid assumption, but will ignore it for know. Both fertility and immigration have been dropping in recent years. The paper claims we will be hard pressed to break 0.8% population growth for the next two decades.

2. Employment Rate which I assume everyone is familiar with. This is the percentage of Americans over 16 that are working. It rose dramatically from 1950 through 2000 in large part because more women entered the work force. As people leave the work force for whatever reason, primarily an inability to find a job or retirement, the percentage drops. The rate peaked at 67.3% in 2000 and currently stands at 63.8%. It is important to note that demographics will cause this ratio to drop as more boomers retire. It is baked into the cake, unless boomers all of a sudden decide NOT to retire.

3. Productivity growth is the unit output you can get from one worker. It is one of the keys to improving living standards for a society. A great example is farming, where one farmer today produces more food than 100 farmers did a century ago. Same thing for many factories with increased automation. Not to mention computers. Once again demographics is working against us. As we age, our contribution to GDP growth declines. It goes to the point that retirees actually cause negative GDP growth.

Rather than list all kinds of tables and numbers, I suggest you read the paper if you are interested. They combine all of these factors together and argue that we are heading for 1.0% GDP growth over the next few decades. Despite what you hear coming out of Washington, it is not clear they can make a substantial difference to the long term growth rates. If you don’t believe that, you need to explain how Washington is going to undo the negative effects of retiring boomers. Somehow I don’t think running with a platform of “We will NEVER let seniors retire” is a winning strategy.

BOTTOM LINE if the 1.0% GDP growth comes true, it will profoundly affect investments in a negative way. Real returns from both equities and fixed income will be lower. Stated differently, all else being equal, you want to invest in faster growing countries. Unfortunately, the US probably will not be part of the fast growth club for the foreseeable future.

Pretty darned important investing implications, so I suggest you at least skim over the 6 page whitepaper.